Are today’s digital business valuations realistic?

The recent acquisition of WhatsApp at $19 billion has got valuations of digital companies into the conversation topics of most corporate folks. Most recently, a manufacturing veteran was complaining to me on how his company’s 100-year heritage, huge global revenues, large technical teams and intellectual property are still not enough to be able to generate the kind of valuation that digital companies with paltry revenues are able to garner.

He felt that markets are not being fair and was quite convinced that sooner or later there will be a correction in valuation.

Personally I am quite bullish about the future of digital businesses and gave him my views that the valuation of WhatsApp was actually based on the 1 billion installed base of customers, the mobile synergy to the Facebook business model, the competitive context of other bidders etc.

But at the end of the conversation the question that still remained on the table was, while there is value in the acquisition, is the $19 billion value fully justified. Will the WhatsApp business eventually generate revenues that will recover the investment. As I pondered over the question my concern was are we seeing another 1999 like dot.com bubble in the making.

Now I was in the digital business in 1999, and in my small way was part of building the boom but I can say with all conviction that the overall environment in today’s economy is very different from the situation in ’99. The internet penetration is way higher now, especially with the presence of mobile internet. Also the improvement in payments, logistics, analytics, location relevance… etc. have made the impact of digital on people’s life and economy quite real.

However, in order to convince my manufacturing industry friend on the power of digital disruptions and share my thoughts on how I see the valuations of digital businesses to be done, I took a simple digital business as an example, the simple taxi ordering app.

The taxi ordering app businesses in Malaysia and the rest of Southeast Asia is growing quite fast, and some of the apps are breaking out and gaining traction. In the venture capital circles already there are conversations going on what should their fair value be. The last I heard was the valuations that were being bandied around were in the region of a few millions.

So as I told my manufacturing industry friend, since both of us use taxis a fair bit and often end up calling for a taxi, we should be able to sit and work out a rough valuation of these app companies over a cup of coffee without having to get confidential data from the companies themselves.

For those who call a cab know that the sole revenue that gets generated is a fee that one pays when one calls a cab, in the case of Malaysia the amount is 2 ringgit for every call. And the way the revenue is split between the app company and the taxi company is 50:50, so the net the taxi app company makes is 1 ringgit for every call that it completes, i.e. manages to link the caller with an available taxi. The same model will be relevant for other markets too.

Obviously for peak periods there is an opportunity to charge a higher amount but for the purpose of this illustration we did not really take this into account.

Again for the purpose of illustration we took Kuala Lumpur as the base, the number of taxis in Kuala Lumpur is about 37,000, and assuming the largest player in the market manages to get just about 50 per cent share of the taxis the base would be about 18,000 taxis. Though currently the numbers of taxis with each of the app brands in the market are way lower, more in the 2,000-5,000 region. With a view to defining the future value of the business we decided to work out a more optimistic scenario of 50 per cent of base and use it to reflect the upsides of the business from rest of Malaysia outside of Kuala Lumpur.

The number of app-based transaction per taxi was assumed at 5 a day, this is an anecdotal estimate based on some of the conversations I have had with taxi drivers in the recent past in Kuala Lumpur.

So based on this quick math it gives a projected revenue of the largest app company at 90,000 ringgit per day, and that translates approximately to revenue of about 33 million ringgit per year. So at a revenue to market value multiple of 10 the market capitalisation of the venture would be 330 million ringgit on the basis of a single market. While this is literally back of the envelope calculations done over a cup of coffee it gives a sense of the future value of the business.

So any acquisition of the largest app organization in the country needs to be grounded on the 330 million ringgit value and any number above that will be seen as over valuing.

While we can debate of the details of this valuation, the same principles should hold true for any other digital businesses and its valuations. As business insiders or lay investors we can use the same valuation principles to judge acquisitions and decide if it is fair value or just a bubble.

The recent acquisition of WhatsApp at $19 billion has got valuations of digital companies into the conversation topics of most corporate folks. Most recently, a manufacturing veteran was complaining to me on how his company’s 100-year heritage, huge global revenues, large technical teams and intellectual property are still not enough to be able to generate the kind of valuation that digital companies with paltry revenues are able to garner.

He felt that markets are not being fair and was quite convinced that sooner or later there will be a correction in valuation.

Personally I am quite bullish about the future of digital businesses and gave him my views that the valuation of WhatsApp was actually based on the 1 billion installed base of customers, the mobile synergy to the Facebook business model, the competitive context of other bidders etc.

But at the end of the conversation the question that still remained on the table was, while there is value in the acquisition, is the $19 billion value fully justified. Will the WhatsApp business eventually generate revenues that will recover the investment. As I pondered over the question my concern was are we seeing another 1999 like dot.com bubble in the making.

Now I was in the digital business in 1999, and in my small way was part of building the boom but I can say with all conviction that the overall environment in today’s economy is very different from the situation in ’99. The internet penetration is way higher now, especially with the presence of mobile internet. Also the improvement in payments, logistics, analytics, location relevance… etc. have made the impact of digital on people’s life and economy quite real.

However, in order to convince my manufacturing industry friend on the power of digital disruptions and share my thoughts on how I see the valuations of digital businesses to be done, I took a simple digital business as an example, the simple taxi ordering app.

The taxi ordering app businesses in Malaysia and the rest of Southeast Asia is growing quite fast, and some of the apps are breaking out and gaining traction. In the venture capital circles already there are conversations going on what should their fair value be. The last I heard was the valuations that were being bandied around were in the region of a few millions.

So as I told my manufacturing industry friend, since both of us use taxis a fair bit and often end up calling for a taxi, we should be able to sit and work out a rough valuation of these app companies over a cup of coffee without having to get confidential data from the companies themselves.

For those who call a cab know that the sole revenue that gets generated is a fee that one pays when one calls a cab, in the case of Malaysia the amount is 2 ringgit for every call. And the way the revenue is split between the app company and the taxi company is 50:50, so the net the taxi app company makes is 1 ringgit for every call that it completes, i.e. manages to link the caller with an available taxi. The same model will be relevant for other markets too.

Obviously for peak periods there is an opportunity to charge a higher amount but for the purpose of this illustration we did not really take this into account.

Again for the purpose of illustration we took Kuala Lumpur as the base, the number of taxis in Kuala Lumpur is about 37,000, and assuming the largest player in the market manages to get just about 50 per cent share of the taxis the base would be about 18,000 taxis. Though currently the numbers of taxis with each of the app brands in the market are way lower, more in the 2,000-5,000 region. With a view to defining the future value of the business we decided to work out a more optimistic scenario of 50 per cent of base and use it to reflect the upsides of the business from rest of Malaysia outside of Kuala Lumpur.

The number of app-based transaction per taxi was assumed at 5 a day, this is an anecdotal estimate based on some of the conversations I have had with taxi drivers in the recent past in Kuala Lumpur.

So based on this quick math it gives a projected revenue of the largest app company at 90,000 ringgit per day, and that translates approximately to revenue of about 33 million ringgit per year. So at a revenue to market value multiple of 10 the market capitalisation of the venture would be 330 million ringgit on the basis of a single market. While this is literally back of the envelope calculations done over a cup of coffee it gives a sense of the future value of the business.

So any acquisition of the largest app organization in the country needs to be grounded on the 330 million ringgit value and any number above that will be seen as over valuing.

While we can debate of the details of this valuation, the same principles should hold true for any other digital businesses and its valuations. As business insiders or lay investors we can use the same valuation principles to judge acquisitions and decide if it is fair value or just a bubble.